At the most simplistic level, the IP [intellectual property] issues around the Android situation and certainly the IP issues that we have discussed, it does infringe on a bunch of patents and there are costs associated with that. And this is not just an issue for us. It may also be an issue as some companies have already stated. So there is an upfront fee cost associated with Android that, I think, doesn't make it free.

Microsoft charges OEMs to license its operating systems, adding to the costs of making a product. In the competitive world of phones, that eats into makers' already tight margins. Also, the Windows code is closed, so OEMs cannot easily make customizations.

Google's mobile operating system is attracting phone makers because it doesn't have an up-front licensing fee and — because it's Linux-based — they are free to modify the code to customize their phones' features.

Android is surging in market share and expected to surpass Symbian after 2014 as the number-one mobile phone operating system, Gartner said last week. Windows Mobile, meanwhile, is expected to slip from fifth to sixth place in the rankings — falling behind Linux newcomer MeeGo from Nokia and Intel.

Faced with this prospect, Ellawala is extending the argument Microsoft has made against Linux on PCs and servers — that there's a hidden cost to the operating system. Typically Microsoft has played up development and integration costs of working with Linux, but now on mobile it has the patent saber to rattle to convince phone makers that they're better off using Windows.

Faced with intense competition, Microsoft won't disclose how much money it expects to make from Windows Phone 7 — or when the cash will start flowing. Instead, it sounds like Microsoft expects to endure only losses for the foreseeable future as it develops Windows Phone 7, conducts channel outreach, and generally rebuilds lost market share in mobile.

"It is an investment period. We are very conscious that we do need to create a business here. We can't be in investment mode forever," Ellawala said. "But it is a journey — it's a longer-term proposition for us."

In fighting back against Android, Microsoft has already tied one hand behind its back.

The first Windows Phone 7 phones will only work on GSM. This move means Microsoft is prioritizing Windows Phone 7 in Europe and the rest of the world, where GSM has a strong presence, but not in the US, where GSM comes up against CDMA. A CDMA update for Windows Phone 7 is planned for 2011 instead.

Senior product manager Greg Sullivan toldCnet that the decision was due to lack of resources. "We had to make some trade-offs... Even Microsoft doesn't have unlimited resources. We had to prioritize doing fewer things, really, really well."

This means that Windows Phone 7 handsets next month from Samsung, HTC, LG, Dell, and Asus won't work on Verizon — the largest mobile network in the US — or on Sprint, but phones should work on number-two mobile network AT&T in addition to T-Mobile.

Unfortunately for Microsoft's baby, AT&T is struggling to handle the kind of 3G traffic it hopes to exploit. AT&T is routinely criticized for dropped and lost calls and for spotty coverage. Apple is expected to add Verizon as a carrier of the iPhone in the US, perhaps as early as January 2011. ®